21 October 2021

LSE: Highlights from the ECB’s work on climate-related financial risks and opportunities

It is now almost universally agreed that the impact of climate change will prompt fundamental changes to the global economy, including the financial sector. The financial system can play a crucial role in financing the transition towards a climate-neutral economy, but at the same time it may be prone to climate-related risks that need proper management. In view of the upcoming COP 26 UN meeting and drawing on ECB analytical work, Wouter Coussens, Irene Heemskerk, Wieger Kastelein and Michael Wedow argue that additional tools and ambitious policy reforms are needed to reach both objectives.

The long-term nature of climate risks, the uncertainty about how these risks will manifest over time as well as their mutual interdependence pose a significant challenge. Climate-related risks to the economy and financial sector are usually divided into two categories. Physical risk is the economic impact stemming from the expected increase of natural hazards, both in frequency and magnitude. Transition risk refers to the impact of the potential delayed and abrupt implementation of climate policies to reduce CO₂ emissions. There is uncertainty both around the evolution of the climate itself and about future policies to mitigate climate change. The two risks are not isolated but closely interlinked; e.g. while climate policies, especially if abruptly implemented, may pose risks to certain high polluting sectors, they may reduce physical risks over the medium-to-long term.

While the primary responsibility and powers to mitigate climate change lie with governments, central banks also have a role to play. Central banks could contribute to avoid so called ‘green swan’ risks, i.e. potentially extremely disruptive financial events triggered by climate-related risks that could trigger a financial crisis. To achieve this objective, a better understanding of climate-related risks is essential, accompanied by dedicated analyses to quantify the potential impacts of climate mitigation policies on the overall economy. At the same time, given the key role of the financial sector to mobilise funds towards more sustainable investments, central banks can play a supporting role to transitioning towards a greener economy.

In order to shed light on the risks for the financial system, the European Central Bank (ECB) conducted an economy-wide climate stress test that models climate risks over the coming decades. A stress test is a tool that investigates how banks would be affected under severe but plausible future economic scenarios. The ECB economy-wide climate stress test pushes out the analytical frontier by extending the time horizon to thirty years, by considering both transition and physical risks in the definition of the future economic scenarios, and by using very granular data. It covers approximately four million companies worldwide and 1,600 consolidated banking groups in the euro area.

The results show that euro area firms and banks could be severely affected in a scenario where climate change is not addressed (see Figure 1). In 2050, the average corporate loan portfolio of a euro area bank is almost 8% more likely to default under the hot house world scenario than under an orderly transition scenario. Additionally, banks most vulnerable to climate risk are 30% more likely to default in 2050 compared with 2020 under the hot house world scenario: this increase is about five times larger than the increase of an average bank under the same scenario....

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